BBA 3301 Financial Management Course Learning Outcomes

Bba 3301 Financial Management 1course Learning Outcomes for Unit Iv

BBA 3301, Financial Management 1 Course Learning Outcomes for Unit IV Upon completion of this unit, students should be able to: 4. Apply measures of risk in financial analysis. 4.1 Explain risk-return relationships including decomposing sources and measures of risk. 4.2 Calculate holding period returns. 4.3 Apply two models of risk-return including the capital asset pricing model and portfolio theory.

Reading Assignment Chapter 7 An Introduction to Risk and Return - History of Financial Market Returns, pp. Chapter 8 Risk and Return - Capital Market Theory, pp. Unit Lesson In the last unit, the time value of money concepts highlighted how investments come about over time. For this unit, the discussion will explain how risk and return influence capital costs. Risk and return accounts for why investments have different values depending on their risk.

Take the case of Ronald Garner. Ronald Garner is starting his career and wants to set aside money for retirement. Ronald's dad, Henry Garner, has just retired and wants to keep his retirement so money is available when he needs it. Both Ronald and his dad have a goal of having enough money for retirement, but Ronald has 40 years before he expects to retire, and Henry is at retirement age now. Because Ronald has 40 years until he retires, he thinks he can take a more gutsy investment strategy, allowing him to invest in securities offering higher returns.

Ronald has heard about some new high-tech digital printing companies getting started and wants to invest in them. Although these companies have not yet perfected their product, he believes the company has great potential. Conversely, Ronald's dad, Henry, wants to not risk losing his invested capital. Henry looks for safer investments with a track record of paying consistent dividends. Henry can keep his portfolio and ensure enough is available for retirement.

Henry had a conversation with his son about risk and return explaining higher risk results in higher expected returns. This principle separates father and son in their investment strategies. Although Ronald has a willingness to take greater risk, he also exposes his portfolio to greater risk. Henry wants to avoid added risk and looks for stability and consistent returns. Expected returns come from returns expected based on expected cash flows from dividends and appreciation realized in the past.

Appreciation results from gains resulting from holding an investment. Henry can estimate his holding return by assigning a probability a certain return will result from a given investment and adding any cash return from dividends paid. For example, holding or cash return results from the ending stock price plus any cash dividends minus the beginning stock price. Henry could also assign probabilities of different economic states that could result like a recession, moderate growth, or strong growth. These estimates, when applied to holding gain, will result in an expected value as follows: E(r) = (r1 x Pb1) + (r2 x Pb2) + ... + (rn x Pbn) where E means expected return; r is rate of return, and Pb is probability.

Henry can further measure risk by calculating variance and standard deviation of his investments. Variance is simply the square of any difference between realized return and expected returns. Squaring the difference removes any negative values measuring differences between realized and expected returns in positive terms. Once calculated, Henry needs to apply a probability of occurrence to each investment resulting in the variance.

After calculating variance, Henry can calculate standard deviation (σ) by taking the standard deviation of variance as follows (Titman, Keown, & Martin, 2014, p. 197): σ = √(∑(rᵢ - E(r))² * Pᵢ). For example, the following table shows how to calculate expected values, variance, and standard deviation: Despite these measures' usefulness in assessing risk exposure, no assurance exists things will go as planned. Under the efficient market theory, markets will reflect varying degrees of information at a given time but not always as quickly as thought. Ronald talked with his dad about different theories of market efficiency, such as the weak, semi-strong, and strong-form models of market efficiency.

These theories address the extent to which markets reflect information in security prices. Weak-form efficient markets theory asserts securities reflect all past market information. Semi-strong efficient markets theory says securities reflect all publicly available information. Strong-form market efficiency espouses the idea that securities reflect all public and private information. Behaviorists assume markets are not always rational and market prices do not always reflect all information.

Ronald has much to think about after discussing these views with his dad. Another theory Ronald discussed with his dad is portfolio theory, which showed him he could erase certain risks through diversification because risk for various securities can move in different directions than the market. Henry explained to Ronald, he can remove most market risk by keeping a diversified portfolio. Ronald can calculate portfolio risk using the following formula (Titman, Keown, & Martin, 2014, p. 226): σ_p = √(w₁² σ₁² + w₂² σ₂² + 2 w₁ w₂ Corr(1,2) σ₁ * σ₂), where σ_p stands for portfolio standard deviation, wᵢ for the proportion of total investment in each security, σᵢ for the individual security’s standard deviation, and Corr(1,2) for the correlation between the returns of the securities.

Henry explained to Ronald only firm-specific risk (unsystematic risk) does not benefit from diversification because such risk does not stem from market movements but from risk unique to a given firm. Portfolio diversification eliminates market (systematic) risk exposure because investments in different industries do not all move with the market in the same direction. A diversified portfolio allows an investor to balance risk movements.

Besides portfolio theory, Henry said another way to explain systematic risk is to use the capital asset pricing model (CAPM). CAPM is a simple risk measure explaining how an investment contributes to the risk of a market portfolio. A beta coefficient, denoted by β, explains to what extent an investment's returns vary with market risk. Henry expressed CAPM for a portfolio by the following formula (Titman, Keown, & Martin, 2014, p. 237): Expected Return = Rf + β (Rm - Rf), where Rf is the risk-free rate, β (beta) measures the sensitivity of the investment to market movements, Rm is the expected return on the market portfolio.

Although Henry explained these two models to Ronald, he had to still think about different mixes of investments for his portfolio. Ronald has an interest in an investment with high reward potential, but it comes with a high risk. Ronald needed to balance his portfolio by finding securities to invest in with beta coefficients that run counter to one another to eliminate risk. Henry is in a different position wanting stable returns without taking on any added risk. Steady returns may come from investments in more mature companies with a track record of paying dividends.

In a world where people sky-dive and bungee jump for pleasure, and gambling is a multi-billion dollar business, it is clear that human beings collectively are sometimes attracted to risk and that some are more susceptible to its attraction than others. While psychoanalysts—at the beginning of the twentieth century—considered risk-taking behavior to be a disease, the fact that it is so widespread suggests that it is part of human nature to be attracted to risk, even when there is no rational payoff to being exposed to risk. The seeds, it could be argued, may have been planted in our hunter-gatherer days when survival mandated taking risks and there were no "play it safe" options (New York Stern School of Business, n.d.). At the same time, there is evidence that human beings try to avoid risk in both physical and financial pursuits. The same person who puts his life at risk climbing mountains may refuse to drive a car without his seat belt on, or to invest in stocks because he considers them to be too risky. Some people are risk takers on small bets but become more risk-averse on bets with larger economic consequences. Risk-taking behavior can change as people age, become wealthier, and have families.

In general, understanding what risk is and how we deal with it is the first step to effectively managing that risk (New York Stern School of Business, n.d.). In summary, both risk and return influence securities values. Investors rarely have identical aversion to risk. Some investors prefer a more aggressive strategy with more risk but with an expectation of greater returns. Other investors prefer a stable strategy sacrificing higher returns for less risk. Investors expect returns commensurate with what they risk. Markets have some investors with superior information to others under the behavioral view. Efficient markets assume investors cannot beat the market because market prices reflect information instantaneously. Measures of risk include portfolio theory, which looks at variations from mean returns through measures like variance and standard deviation. Another measure is beta, which is a key component of the capital asset pricing model. Beta measures movement of an investment with or against the market. Most often investors have different views influencing their aversion to risk.

Paper For Above instruction

Risk and return are foundational concepts in financial management, shaping investment decisions and influencing perceptions of asset value. Understanding how risk affects expected returns allows investors to make informed choices aligned with their risk tolerance and investment goals. This paper explores the relationship between risk and return in financial markets, examines measures of risk such as variance, standard deviation, and beta, and discusses models like portfolio theory and the Capital Asset Pricing Model (CAPM). Using real-world examples and theoretical frameworks, the paper demonstrates how investors assess, measure, and manage risk to optimize their investment portfolios.

The relationship between risk and return is rooted in the principle that higher risk should be compensated by higher expected returns. Investors, both institutional and individual, seek to balance risk and reward, often differing in their tolerance and preferences. Ronald Garner and his father Henry exemplify contrasting approaches: Ronald, with a long-term horizon, is willing to accept higher-risk investments with the prospect of greater returns, such as emerging high-tech companies, whereas Henry, nearing retirement, favors low-risk investments with stable dividends. This divergence illustrates the fundamental investor behavior of risk aversion and risk-seeking, shaped by factors such as age, income, investment horizon, and personal risk appetite.

Measuring Risk: Variance, Standard Deviation, and Beta

One of the core measures of risk in investment analysis is variance, which quantifies the dispersion of returns around the expected value. Variance is calculated by taking the squared differences between actual returns and the mean expected return, weighted by the probability of each state of the economy. Variance's square root yields the standard deviation, a widely used measure for assessing investment volatility. For example, Henry estimates his investment risk by calculating the variance and standard deviation based on the probabilities assigned to different economic conditions, such as recession or growth, which influences his expected return.

In addition to these measures, beta coefficient plays a critical role in evaluating systematic risk through the CAPM framework. Beta measures the sensitivity of an asset's returns relative to the overall market return. A beta greater than one indicates higher volatility than the market, implying higher risk and potentially higher returns, whereas a beta less than one suggests lower relative risk. The CAPM formula, Rᵢ = Rf + βᵢ(Rm - Rf), encapsulates the relationship between risk and expected return, guiding investors in assessing how individual securities contribute to portfolio risk. For example, a high-beta stock may offer substantial returns but also higher volatility, aligning with Ronald's risk-seeking strategy.

Portfolio Theory and Diversification

Portfolio theory emphasizes diversification as a means of risk mitigation. By investing in a mix of assets with varying correlations, investors like Henry aim to eliminate unsystematic, firm-specific risk, leaving only systematic market risk. The total risk of a diversified portfolio is less than the sum of individual risks, thanks to the diversification effect. The correlation coefficient between asset returns determines how effectively diversification reduces risk: negative or low correlations result in greater risk reduction.

Henry demonstrates this concept by calculating portfolio risk using the weighted standard deviations of individual securities, along with their correlation coefficients. This approach underscores the importance of constructing portfolios that balance risk and return, especially for risk-averse investors. Ronald, on the other hand, seeks securities with low or negative correlations to minimize volatility while targeting high returns, illustrating the practical application of portfolio diversification.

Market Efficiency and Behavioral Perspectives

Market efficiency theories—weak, semi-strong, and strong—provide insights into how quickly and accurately information is incorporated into asset prices. The weak-form posits that past prices are fully reflected, while the semi-strong asserts all publicly available information is embedded. The strong-form claims all information, public and private, is reflected in prices. Behavioral finance challenges the notion of perfectly efficient markets, emphasizing that investors' psychological biases can lead to mispricing and opportunities for abnormal returns.

Ronald’s discussion with his father about these theories highlights the debate between rational market hypothesis and behavioral anomalies. For instance, while the CAPM assumes investors are rational and markets are efficient, behavioral biases such as overconfidence, loss aversion, and herd behavior can distort prices and create temporary mispricings. Recognizing these factors enables investors to develop strategies that exploit inefficiencies or align their risk preferences more effectively.

Risk-Taking Behavior and Human Nature

Risk-taking behavior appears intrinsic to human nature, influenced by evolutionary survival instincts and psychological traits. From early hunter-gatherer days, humans were conditioned to take significant risks for survival, which persists in modern pursuits like investing. However, individuals' risk attitudes vary widely, influenced by age, wealth, experience, and personal circumstances. Younger investors may favor riskier assets with higher potential returns, while older individuals prioritize capital preservation.

Understanding these behavioral aspects is crucial for effective risk management. Investors must assess their own risk tolerance and develop strategies consistent with their psychological predispositions. Recognizing that humans are inherently attracted to risk, even when rational analysis suggests caution, underlines the importance of discipline and knowledge in investment decision-making.

Conclusion

In conclusion, the interplay of risk and return fundamentally influences securities valuation and investment decisions. Quantitative measures like variance, standard deviation, and beta facilitate understanding and managing risk, while models such as portfolio theory and CAPM offer frameworks for diversification and risk assessment. Recognizing the behavioral tendencies that drive risk-taking enhances investor awareness and strategy formulation. Ultimately, a comprehensive grasp of risk and return enables investors to craft portfolios aligned with their objectives, risk appetite, and market conditions, fostering more effective financial management.

References

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